Roelof Salomons

The Equity Risk Premium: Emerging versus Developed Markets

This paper gives an empirical view of the ex-post equity risk premium in a number of international markets with special attention to emerging ones. Our study yields interesting implications for finance. Firstly, we find that the equity risk premium in emerging markets is significantly higher than in developed markets. Secondly, the extent to which emerging stock markets reward investors is varying through time. We cannot link this time varying nature with the presence of a structural break based on stock market liberalisations, but observe that the differences are of a more cyclical nature.

A Tactical Implication of Predictability: Fighting the FED Model

This article confirms that high earnings yields portend high equity returns. Absolute valuation levels of equity have predictive power over future long-run equity returns. The predictability is far less powerful in the short term. On a tactical investment horizon, investors tend to rely on the relative valuation of equity versus bonds to gauge whether equity markets are attractive. The FED model, which compares earnings yield and bond yield, is the preferred yardstick in the finance profession. First, this article examines the FED model and shows that it is not only theoretically flawed, but also unable to predict equity returns over long sample periods. Second, Salomons improves the model by adding corrections for perceived risk, enabling a better fit of the data. The article concludes with its main innovation, testing a tactical asset allocation model constructed on the basis of the improved FED model. A model portfolio taking advantage of the short-term deviation in relative value, corrected for risk, leads to superior performance.

Monetary Transmission and Equity Markets in the EU

We assess the role of equity markets in the transmission of monetary policy in the EU. We use a structural VAR model based upon the models of Kim and Roubini [2000] and Brischetto and Voss [1999] and we find that there are differences in monetary policy transmission across our sample of countries. The largest output losses following a monetary shock are seen in a core of euro area countries: Austria, Belgium, Finland, France, and Germany. Germany also displays the largest response of prices and is followed by Austria and Finland. Variance decompositions also suggest that the bank based core euro area countries are different from market based countries. As regards the channels of transmission we find no evidence to suggest an equity wealth effect channel in the euro area and only circumstantial evidence for the UK. We do, however, find that those countries that use equity finance (the UK and the Netherlands) suffer smaller output losses following a monetary shock indicating that a bank lending channel is less likely to be present in these countries.

A Theoretical and Practical Perspective on the Equity Risk Premium

In historical perspective, equity returns have been higher than interest rates but have also varied a good deal more. However, the average excess return has been larger than what could be expected based on classical equilibrium theory: the equity risk premium (ERP) puzzle. This paper has two objectives. First, the paper presents a comprehensive overview of the vast literature developed aimed at adjusting theory and testing the robustness of the puzzle. Here we will show that the failure of theory to link asset prices to economics is mostly quantitative by nature and not qualitative (anymore). Second, beyond providing a survey of theory, we aim for a relevant practical angle as well. Our main contribution is that we spend time on why returns have been higher than investors reasonably could have expected. We present evidence that forecasts of equity returns can be enhanced by valuation models: low valuation levels (low price-to-earnings ratios) portend high subsequent returns. While conventional wisdom (several years ago) was to use historical returns to forecast future returns, a growing consensus now recognizes that the predictive power of valuation ratios is preferred. Finally we provide some practical implications based on this predictability. While the ERP is essentially a long-term issue, the likelihood of a lower risk premium increases risk for many and means that short-term volatility might not be neglected.

The Determinants of the Long-Run Equity Risk Premium

One of the anomalies in finance is the equity risk premium in relation to normal risk attitude of financial agents. We address the role of the equity market in a Ramsey-type model of long-run growth. The main claim of the paper is to show that, if even in the long run equity and debt are imperfect substitutes, we can determine the long-run determinants of the equity risk premium. The first argument to assume heterogeneity between equity and debt is that equity (and not debt) holds voting power, which might increase the role of the consumer as owner of the firm in improving long-run productivity. But holding equity might lead to disutility, since the right to vote might be nonattractive to carry. A second alleged difference between equity and debt is that debt should be more sensitive to inflation than equity. We discuss the role of voting power and burden and the impact of inflation in a growth model. We test the empirical implications of the model using data for 30 countries using data over the years 1981-2001.

Corporate Governance and Stock Returns in Asia

Despite years of study, the impact of firm-level governance on stock returns is not clear, especially in non-U.S. markets. We investigate the returns of governance-based trading strategies in Asia, using bias-free return data and CLSA governance ratings. We argue that poor governance should be associated with higher market risk. We find that a portfolio of poorly governed firms has a higher market beta, higher expected return and higher realized return, compared with a good governance portfolio. In contrast to some earlier studies, we find no abnormal returns after adjusting for risk and country effects. Only investors who can predict in advance which firms will improve their governance can earn abnormal returns.